A New York state appeals court has revived a lawsuit brought by the state attorney general's office against Charles Schwab & Co Inc over claims that the brokerage firm fraudulently marketed auction-rate securities.

Auction Rate Securities are a type of long term bond which, via weekly (or monthly) "auctions", allow holders to sell off the debt to others and recoup their money at short notice. In this way, auction rate securities were intended to combine the higher interest rates earned by long term loans with the accessibility of short term loans. In other words, you earn a higher interest rate and you can get your money out when you need it - unlike, say, lending money via a CD, which doesn't allow you to get your money back until a set date.

Auction rate securities are often issued by municipalities, schools, and hospitals (those in public finance). Thus, these securities often have the added benefit of being tax-free and were thought to be relatively reliable. As a result of these two benefits (liquidity and higher interest) many companies and high net worth individuals - particularly those who need to access money at short notice - invested in these instruments.

The market for these securities was made by four major investment banks - Citigroup, UBS, Morgan Stanley, and Merrill Lynch - and these banks typically acted as bidders of last resort, in the event that no buyer for a particular ARS could be found in the dutch auction for the assets. These auctions took place every 7, 28, or 35 days, with the interest paid out at the end of the auction period. But in February 2008 these banks responded to a decline in demand for the securities, and their own liquidity issues as a result of the credit crunch, by refusing to act as a last-resort bidder. Companies that had invested in Auction Rate Securities were unable to sell and recoup their money. Thus the issuers of such bonds also suffered with substantially higher interest rates.

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Auction Rate Securities held by different companies. The failure of Auction Rate Securities auctions in February `08 left these companies unable to access cash from what were previously believed to be liquid investments.[1]

Who's Impacted

Many companies hold auction rate securities. As a result of the auction failures, what these companies previously believed to be a cash equivalent or short-term debt which they could sell at any time became long-term debt which they cannot access. They will have to reclassify these investments as such on their balance sheet. Although these investments still earn interest (often at a higher rate because of the auction failures) the company cannot access its money and may have trouble paying the bills. Any revival in the Auction Rate Securities market would benefit these companies in the form of additional liquid assets. The following companies have notable exposure:

In January, Deloitte & Touche began warning clients that Auction Rate Securities were being affected by the turmoil in the credit markets, and therefore they were not worth as much as their face value; this drop in value would have to be reflected in companies' balance sheets and earnings releases. This precipitated a run on the bank - companies rushed to sell.

As the the credit crisis worsened, and investment banks own balance sheets were taking a hit as a result of write-downs, they stopped stepping in to buy auction rate securities from their clients and the auctions began failing. Those left holding auction rate securities were unable to unload them.